The British banking system's demand for cash reserves

Abstract

There has been considerable controversy in the United Kingdom about the most appropriate method of conducting monetary policy. This controversy has focused on the concept of the monetary base and its present and potential usefulness as an instrument of monetary policy. This paper is intended to help resolve this controversy by analyzing an important part of the monetary system in existence in the United Kingdom during the years 1973–1978 and referred to as the ‘present’ system in this paper. First, a brief description of the relevant aspects of the British monetary system is presented. Next, a theoretical model of the banking system's demand for cash reserves (i.e., vault cash plus cash deposits at the Bank of England) is developed. This model is estimated and conclusions are drawn based on the empirical results. It is found that in the present British monetary system, banks demand for cash reserves is a well defined and well-behaved function of bank deposit liabilities and a few other observable variables. Thus a policy of achieving monetary growth targets by means of conventional open-market operations by the Bank of England—that is, by manipulating the supply of monetary base—appears to be feasible under present circumtances, assuming that the demand for the monetary base by non-banks is also well defined.